The Determinants of Corporate Bond Yield Spreads

1. The Determinants of Corporate Bond Yield Spreads in South Africa: Firm-Specific or Driven by Sovereign Risk? Martin Grandes (DELTA and OECD Development Centre, Paris) Marcel Peter (HEI Geneva and IMF)

2. This presentation: • Motivation and policy relevance • What do we know about it? • The determinants of corporate default risk premia in theory • Firm-specific variables • Sovereign default risk • Empirical evidence for South African corporates • Data sources and sample period • Econometric framework • Results • Concluding remarks and policy recommendations

3. Motivation and Policy Relevance Global: • Feeds into the Post-Monterrey agenda: • Cheaper finance for development, debt sustainability • Higher rates of investment required in LDC’s to achieve MDG Regional: • Contributes to NEPAD Capital Flows Initiative (CFI) and the NEPAD-OECD Africa Investment Initiative • Aim: increasing private capital flows to Africa, filling the resource gap • Two priorities: i) address investors’ perception of Africa as a "high-risk" continent ii) promote the deepening of financial markets within countries, as well as cross-border harmonisation and integration. Positive spillover effects. (see OECD DEV WP 231 or session I tomorrow!)

4. Motivation and Policy Relevance Domestic • Researches a unique case in Africa, • A liquid bond market in local currency. Yet, small “truly” corporate bond market but: • Good prospects for further development (see RMB and BESA) • Big firms tapping this market. Could help inform decisions made by other potential issuers => alternative, cheaper source of finance • Scope for lowering corporate debt costs when public solvency improves • Source of concern: • The cost of capital (of which debt cost is a component) is a critical driver of long-term growth. • Relatively high real cost of capital blamed for sluggish long-term growth (see also Michael Power’s presentation)

5. What do we know about it? Main questions this study aims to answer: 1) Can we observe something like a “sovereign ceiling” in local-currency-denominated corporate bond yield spreads? • In other words, Is a given increase in sovereign risk associated with a more or less than proportionate increase in South African corporate bond yield spreads? 2) Do idiosyncratic (i.e. company-specific) factors help explain corporate default risk premia? • Very scant literature on developing countries. • Virtual inexistence of long-term, fixed rates, local-currency denominated issues (“Original Sin”) • Many corporate bond markets still poorly developed • Only Durbin and Ng (2001); foreign-currency denominated issues; no firm-specific controls. Main finding: the “sovereign ceiling” doesn’t hold, esp. in low-risk countries

6. The determinants of corporate default risk premia. Theory The Cost of debt for an emerging market borrower This morning This presentation

7. The determinants of corporate default risk premia. Theory • Firm-specific variables (Black and Scholes, 1973; Merton, 1974; Shimko et al (1993), others)

8. The determinants of corporate default risk premia. Theory • Sovereign default risk and the “sovereign ceiling” if => the “ceiling” in spreads applies if => the “ceiling” in spreads does not apply In this latter case, corporate spreads higher than sovereign spreads due to higher firm stand-alone risk

9. Empirical evidence for South African corporates • Data sources and sample: • BESA and DATASTREAM. • Excludes parastatals • Excludes non-listed (at JSE) corporates • Excludes illiquid issues => We found 12 bonds: October 1997-May 2003. Monthly observations • Half banks, half industrials • Benchmark bonds: EBRD, EIB and IBRD (World Bank) ZAR denominated issues • Econometric framework • Panel data estimations. Modern techniques. Two equations: • Corporate spread levels • Corporate spread differences Therefore, task is to test the significance and value of:

10. How do we compute corporate spreads? Example I: ABSA 05 In % points

11. How do we compute corporate spreads? Example II: ISCOR 03 In % points

12. Empirical evidence for South African corporates • Econometric results Note: ** and * means the variable is statistically significant at the 1% and 5% level, respectively.

13. Main results & policy recommendations • Indirect sovereign risk is less than 100% • Hence, the “sovereign ceiling” as defined does not apply for local-currency bond issues • Corporate default risk is also explained by relatively higher firm stand-alone risk. This is due, according to our findings, to: • An increase in the firm’s leverage • A rise in the volatility of returns on the firm value • Shorter remaining time to maturity • Higher risk-free interest rate volatility, when firms are highly leveraged • However, sovereign risk is still an important determinant of corporate debt cost! • Scope for policies targeting public sector solvency

14. Annex South African Corporate spreads I Basis points

15. Annex South African Corporate spreads II Basis points